SEC Rule 506(b)

Rule 506(b) is the main legal pathway that hedge funds and other private companies use to raise money without having to register their securities with the SEC. This rule creates what's called a ""—essentially a clear set of guidelines that, when followed, protect issuers from securities law violations.

The rule falls under Section 4(a)(2) of the , which broadly exempts private transactions from registration requirements. However, rather than relying on this general exemption (which can be vague and risky), Rule 506(b) provides specific, objective standards that give fund managers much greater legal certainty.

This exemption allows private funds to raise unlimited amounts of money while keeping their offerings private. The key difference between Rule 506(b) and its newer counterpart, , is that 506(b) completely prohibits any form of or . All investor outreach must happen through private, existing relationships.

To use Rule 506(b), fund managers must follow several strict requirements. First and most importantly, they cannot use any form of general solicitation or public advertising. This means no website marketing, social media campaigns, mass emails, or public presentations. All investor communications must happen through pre-existing relationships or private, one-on-one communications.

The rule allows sales to an unlimited number of —wealthy individuals or institutions who are presumed sophisticated enough to evaluate investment risks on their own. However, offerings can also include up to 35 non-accredited investors, but only if these investors are financially sophisticated themselves or work with a who can evaluate the investment for them.

When non-accredited investors are involved, the disclosure requirements become much more demanding. Fund managers must provide comprehensive that are essentially equivalent to what would be required in a public offering. This includes audited financial statements and detailed risk disclosures. Because of this added complexity and cost, most hedge funds choose to limit their offerings to accredited investors only.

Fund managers using Rule 506(b) must file with the SEC within 15 days of their first securities sale. This is a relatively simple notice filing that provides basic information about the fund, the offering terms, and how the money will be used. Importantly, the SEC doesn't review or approve these filings—it's just a notification requirement.

One major advantage of Rule 506(b) is . This means that while fund managers must still comply with federal securities laws, they're generally exempt from state securities registration and review requirements. However, states can still require notice filings and charge fees. Most states require these filings within 15 days of the first sale to residents of that state.

The rule also includes "" provisions that prevent certain people from using the exemption. If key people involved in the offering—such as the fund manager or major stakeholders—have been convicted of securities crimes or sanctioned by regulators, the fund may not be able to use Rule 506(b). This requires careful background checking of all involved parties.

Even though Rule 506(c) was introduced in 2012 to allow general solicitation (with stricter verification requirements), Rule 506(b) remains the preferred choice for many hedge fund offerings. The main reason is that 506(b) has more flexible requirements for verifying that investors are accredited—managers only need a "reasonable belief" rather than taking "reasonable steps to verify" as required under 506(c).

The combination of unlimited fundraising capacity and federal preemption from state makes Rule 506(b) particularly attractive for large capital raises. Its well-established legal framework and extensive regulatory guidance give fund managers confidence in using this exemption, which is why it continues to be the dominant choice for private fund formation and operations.

In practice, most hedge fund managers structure their Rule 506(b) offerings to include only accredited investors. This avoids the extra disclosure requirements and complexity of verifying that non-accredited investors are sophisticated enough to participate.

Since general solicitation is prohibited, fund managers must rely on their existing networks to find investors. This typically includes relationships with current investors, referrals, and introductions through intermediaries like placement agents or services. All marketing must be done through private, relationship-based communications.

Securities sold under Rule 506(b) are considered "restricted," meaning investors can't easily resell them. They would need to either register the securities with the SEC or find another exemption (like ) to sell. This restriction affects investor liquidity and must be clearly explained in all fund documents.